New criteria set out by the Bank of Spain will have a binding nature for supervised financial entities
On 30 April 2013 the supervisory body of the Bank of Spain sent a formal communication to the financial entities subject to its supervision containing the criteria to be used with regard to the definition, documentation, follow-up and review of credit refinancing and restructuring transactions (the Communication).
These criteria set forth by the Bank of Spain are a step further to Circular 4/2004 and Circular 6/2012 regarding financial information and models on financial statements applicable to banks and other credit entities (please see Client Alert 1043 of 10 June 2010, ‘The Spanish Central Bank Proposes to Toughen Risk Management Principles and Provision Requirements to Financial Entities’).
The Bank of Spain has produced the criteria as a reaction to the heterogeneity observed among financial entities with regard to the accounting treatment of such refinancing and restructuring transactions. The Bank of Spain has been able to gather such evidence as a result of the obligation it introduced in its Circular 6/2012, of 28 September, in which it requested financial entities to provide information on refinancing transactions in the notes to their financial statements.
The objective of the Communication is two-fold: (i) to reinforce debt restructuring policies by introducing criteria ensuring a rigorous treatment of risk by financial entities; and (ii) to make sure that the differences existing among financial entities regarding refinancing operations respond to genuine differences of their business models rather than to different interpretations of Circular 4/2004 and other applicable regulations.
The Communication has a binding nature upon the supervised financial entities. Such entities shall moreover subject their current accounting treatment of restructuring and refinancing transactions to an individual review under the criteria set out in the Communication and shall submit a report to the Bank of Spain’s Inspection Services presenting their conclusions before 30 September 2013.
Debt refinancing and restructuring policies
In the Communication, the Bank of Spain acknowledges that debt refinancing and restructuring constitute adequate credit risk management instruments, which shall be deployed by financial entities according to the following criteria:
- The decision to grant refinancing or restructuring shall be based on an individual analysis of the current income sources of the debtor, which is meant to enable financial entities to determine the debtor’s real repayment capacity on the basis of its recurring, sufficient and verifiable income. Such income shall be sufficient to cover both the refinanced or restructured debt, as well as any other debt previously assumed by the debtor. In addition to the criteria set out in Circular 4/2004, financial entities shall take into account the debtor’s payment records as well as any previous experiences with the debtor, particularly those relating to past debt refinancing or restructuring.
- The terms and conditions of any debt refinancing or restructuring transaction shall be based on a realistic repayment scheme agreed in accordance to the debtor’s payment capacity and the general economic situation. In this sense, such transactions shall be preferably structured by means of periodic instalments, which should match the debtor’s recurring income, or alternatively, as schemes which are financially equivalent to such instalments.
- Financial entities shall have access to sufficiently updated estimates of the real value of any existing securities and other guarantees, as determined by the market situation at each moment. New securities, collateral or guarantees shall in any case be deemed to be a secondary and exceptional source for the recovery of any due amounts and their value and effectiveness shall be analysed pursuant to the entity’s eventual capacity to foreclose such securities or guarantees under the agreed terms and the foreseeable circumstances.
- Financial entities shall periodically review any decisions adopted in connection with internal restructuring and refinancing policies and procedures in order to identify any incidents, assess their effectiveness and evaluate possible improvements. Financial entities shall particularly implement an internal information system, which enables them to perform individual monitoring of each debt restructuring or refinancing transaction.
Risk in restructuring and refinancing transactions
The Communication furthermore states that restructuring and refinancing transactions may be classified as either “normal risk”, “sub-standard risk” or “doubtful risk” in financial entities’ accounts as per Circular 4/2004. Such transactions shall be classified as “sub-standard risk” in those cases where the requirements for “normal risk” or “doubtful risk” do not apply. The Communication provides that restructuring and refinancing transactions shall be classified as “normal risk” whenever there is objective and verifiable evidence which supports a highly likely chance of recovery of any and all due amounts. The following factors shall be taken into account for “normal risk” classification:
- The absence of clauses which prevent financial entities from determining the debtor’s real repayment capacity in the short term (e.g., clauses granting a long pre-amortization period).
- The existence of a debt repayment scheme which adjusts to the debtor’s recurring and verifiable income, once any other previously acquired obligations have been deducted.
- The granting of new effective security or the accession of new guarantors of unquestionable solvency to the facility agreement.
In any case, all those transactions classified as “normal risk” shall be executed according to realistic and prudent risk management principles and they shall be subject to an individual semester review scheme in order to evaluate whether such risk management strategy needs to be amended.
On the other hand, the Communication sets out that any transactions in which the debtor’s repayment capacity is weak, shall be classified as “doubtful risk”. In order to classify a restructuring or refinancing transaction as “doubtful risk”, the following criteria shall be observed by financial entities:
- The granting of new effective security or the fact that all of the due interest rates have been repaid without increasing the previous risk classification.
- The existence of capital pre-amortization periods which are longer than thirty (30) months, except for those cases in which the agreement includes terms which considerably improve the chances of recovery.
- The acceptability of any previous refinancing or restructuring transaction, except in those cases in which there is enough evidence supporting the debtor’s capacity to perform its contractual obligations timely.
Finally, regarding the eventual re-classification of refinancing and restructuring transactions classified as “sub-standard risk” or “doubtful risk” to a lower risk category, the Communication provides that such re-classification will only be permitted if (i) the debtor has duly performed its obligations under the facility agreement for a sufficiently long period; and (ii) after an individual review of the transaction at stake, the financial institutions can determine that an improvement in the debtor’s repayment capacity has occurred. Transactions shall be generally re-classified to “normal risk” in those cases in which (i) debtors have duly performed their obligations for at least one (1) year after the execution of the refinancing or restructuring (six (6) months in the case of loans with monthly instalments guaranteed by the debtor’s principal residence); or (ii) the principal amount due has been reduced at least by ten per cent (10%).
The Communication reflects the increasingly scrutiny which financial institutions are subject to in an uncertain economic scenario in which the reform of the Spanish financial system is close to completion.